Fund name: Royce Financial Services (RYFSX)

Objective: The fund seeks long-term capital appreciation by investing in micro-, small- and mid-cap financial services stocks. The financial services industry includes banks, savings & loans, insurance, investment managers, brokers, and the folks who support them. As of August 2008, the fund may invest up to 35% of its portfolio in international stocks. The fund holds about 100 stocks. The managers look for companies with excellent business strengths, high internal rates of return, and low leverage. They buy when the stocks are trading at a significant discount.

Adviser: Royce & Associates, LLC is owned by Legg Mason, though Royce retains autonomy over its investment process and day-to-day operations. Royce is a smaller-company value specialist with 27 funds (including closed-end and variable annuity accounts). It was founded by Mr. Royce in 1972 and now employs more than 100 people, including 29 investment professionals. As of 12/31/2007, Royce had $30 billion in assets under management; $123 million of that amount was personal investments by the Royce staff.

Manager: Charles Royce and Chris Flynn. Mr. Royce is the advisor’s founder, president and chief investment officer. He wears a stern expression and a bowtie, and manages or co-manages 13 other Royce funds. Mr. Flynn is an "assistant portfolio manager" and analyst here and on three other funds.

Management’s Stake in the Fund: Mr. Royce has somewhere between $100,000 and $500,000 directly invested in the fund. When you take into account shares held for the benefit of his family, Royce owns about 30% of the entire fund. As of the most recent SAI, Mr. Flynn does not own any shares of the fund.

Opening date: December 31, 2003

Minimum investment: $2,000 for regular accounts, $1000 for IRAs.

Expense ratio:1.49% on an asset base of $8 million, with a 1% redemption fee on shares held less than 180 days.

Comments: Remember all that advice from Baron Rothschild that you swore you were going to take next time? The stuff about buying "when there’s blood in the streets" and the advice to "buy on the sound of cannons and to sell on the sound of trumpets"? Well, here’s your chance, little bubba!

There are few sectors so widely reviled, or so central to the eventual righting of the global economy, as financials. The headlines are apocalyptic. The government is thrashing about. And investors are playing a singularly peculiar game of "can you top this" with their estimates of the damage from the housing-related meltdown. The always-chipper Bill Gross (who, I recently learned, practices yoga) places the cost at a trillion dollars ($1,000,000,000,000) which suggests hundreds of billions in write-downs remain. John Paulson, a hedge fund manager, guesses $1.3 trillion. Bridgewater Associates, which manages $150 billion for high net-worth clients and foreign governments, is thinking $1.6 trillion. Analyst Frank Veneroso of Allianz Dresdner Asset Management tags it as in "the $2 trillion range."

It’s no real surprise, then, that the average financial services fund has lost 30% over the past 12 months and that a bunch (even excluding leveraged sector indexes) are showing losses in the 40-50% range.

But it’s clear that Royce Financial Services isn’t your average financial services fund. It has earned five stars from the good folks at Morningstar. It has earned Lipper’s highest score (a "Lipper Leader") in total return and capital preservation for both the trailing three years and the period since inception. It has posted above-average returns every year since inception and it has placed in the top 10% of its peer-group for the past quarter, year-to-date (through 7/24), trailing twelve months, and trailing 36 months. It has the highest returns over any financial services fund over the past three years (5% per year) and is one of only four such funds which has made any money over that period.

Royce has three distinctions which likely help explain its success in hard times.

Royce focuses on small cap stocks. And smaller companies aren’t, by and large, the ones who concocted the toxic mess. It’s one of only three financial funds with a small cap focus (FBR Small Cap Financial and KBW Regional Banks, an ETF, are the others). Royce has a clear performance advantage over both of the other funds, as well as over Morningstar’s top-rated no-load financial services fund (PRISX, below):

I’ll note a certain irony in the fact that the Royce fund’s biggest losses over the past year come from its investment in FBR. FBR’s manager, sick and tired of his own losses, has moved nearly 40% of his own fund to cash at a time when "cash" largely locks in losses to inflation. ("Ellison’s New Position: Cash Hoard," WSJ, July 24, 2008)

Royce maintains a large and growing international stake. As of June 30, about 15% of the portfolio is invested overseas. A recent investment policy change will allow that to grow to 35% in mid-August. Mr. Royce, in a July 1 interview posted at the fund’s website, argues that the era of U.S. financial dominance is ending. He views the U.S. as slipping from being to world’s dominant economic force (say, a decade ago) to first among equals (currently) to one of the five or six players in the top tier (going forward). As a result, he’s been prospecting international markets for solidly managed firms that evince "sensible and cautious lending habits."

Royce has a solid track record in applying its small cap value disciplines to international investing. It has two global funds (Global Select and Global Value), and two international ones (European Smaller Companies and the just-launched International Smaller Companies). While all of these funds have very short track records ( one to three years), all have performed well, especially in declining markets. Global Select, with a $50,000 investment minimum (sigh), has returns in the top 1% over the past three years. Global Value is in the top 2% over the past year and European Smaller Companies places in the top 10% for the same period.

There are a half dozen financial funds (including Mutual Financial Services) with larger international stakes than Royce holds, but Royce has outperformed all of them in 2008, as well as over the trailing 12- and 36-month periods.

Royce is a long-experienced, conservative manager. Mr. Royce does not like to lose money. He notes that he places "a high premium on absolute performance for all our portfolios" and is especially pleased that the Financial Services fund "held its value best when returns were generally worse. One of our goals in every portfolio that we manage is to lose less during down market phases."

Mr. Royce does not qualify as a cock-eyed optimist. In the fund’s annual report, he suggests that "a bottom has not yet been reached." In his July 1 interview, he opines:

His argument is that "further ahead" translates to something like three to five years, which is consistent with other bears’ guesses that a durable bull market won’t be seen until the second half of the next presidential administration. He does believe that the recovery is apt to be led by small cap value stocks again. He argues that "A volatile stock market has historically been a boon to value investors, and the current period is no exception" and concludes:

Bottom Line: There’s little question that Royce Financial will be a profitable investment in time. The two questions that you’ll need to answer are (1) whether you want a dedicated financial specialist and (2) whether you want to begin accumulating shares during a weak-to-wretched market. The greatest returns will accrue to folks who arrive early, since markets often turn when folks have the least reason for confidence. (The Dow returned 100% in the year following its low – 41.22 – in July 1932, despite the fact that industrial output fell and unemployment rose for the same period.) Mr. Royce has made a substantial commitment of his family’s money to the fund which does suggest his answer to the question.